SHANGHAI, June 22 (Reuters) - The Chinese yuan slipped on Tuesday, giving back more than half the previous day's rally,with hefty dollar buying by state-owned banks suggesting the central bank was using new tactics to stir two-way trade and limit yuan gains.

The yuan initially jumped after the People's Bank of China set the mid-point start to trade at a surprisingly strong 6.7980 per dollar CNY=SAEC, little changed from Monday's close and catching market players off guard when they thought it would try to nudge the currency lower after the previous day's surge.

But the heavy dollar buying quickly drove the yuan CNY=CFXS back from 6.7900 -- the early high and the strongest since its 2005 revaluation -- to as low as 6.8229 before closing at 6.8136,down 0.23 percent from Monday.

The yuan fell back just a day after posting the biggest one-day yuan rise since the revaluation, having jumped nearly half a percent on Monday and almost touching the upper end of the daily trading limits on either side of the mid-point.

Some traders believe the state-owned banks' dollar buying was on behalf of the PBOC to avoid direct market intervention, a tactic often employed in the post-revaluation phase of yuan appreciation from 2005 to 2008 and during the de facto dollar peg of the past two years.

By letting state-owned banks buy dollars, the PBOC is effectively limiting the market's ability to short dollar/yuan - especially since banks are not allowed to hold short positions overnight in the spot currency market.

It appears to be a new strategy, said a senior dealer at a European bank in Shanghai. The central bank needn't intervene in the market, but it can still keep the pace of yuan appreciation under control via control of supply and demand.

TWO-WAY TRADE The state-owned banks were scooping up dollars at a wide variety of levels, suggesting they were not trying to defend the yuan at a certain level, traders said. Since the peg to the dollar was ditched over the weekend, the PBOC appears to be trying to foster much more two-way trade within the daily trading band, seeking to get banks and companies accustomed to greater volatility and to hedging currency risks.

For a chart on yuan volatility: r.reuters.com/ryj43m During the 2005-2008 managed float against a trade-weighted currency basket and the subsequent peg to the dollar, the PBOC often squashed intraday volatility via direct intervention, as well as through guidance with the mid-point and dollar purchases by state-owned banks.

Now it appears to be backing away from direct intervention unless the extremes of the daily trading band are tested. Some traders said the PBOC may have encouraged the dollar buying as a way of stirring more activity within the trading band.

The PBOC made clear that it would not allow the yuan to appreciate sharply and ruled out a one-off revaluation in statements over the weekend announcing the latest yuan reforms. Foreign Ministry spokesman Qin Gang said on Tuesday that yuan reform must remain gradual and controllable.

Dealers also believe the PBOC may have adopted a new formula for setting the mid-point: the yuan's close on the previous day plus the overnight moves in the dollar index .DXY, which gauges the U.S. currency's performance against a basket of six major currencies. Based on that presumed formula and the dollar's stability in early European trade on Tuesday, dealers believed the yuan's mid-point on Wednesday could be set near Tuesday's spot yuan close.

BASKET IN USE Despite the announced intention of controlling the pace of yuan appreciation against the dollar, the PBOC showed it was backing its words with deeds by allowing the yuan to rise against European currencies on Tuesday.

The PBOC set the yuan's mid-point higher against the euro EURCNY=SAEC, at 8.3816, and against sterling GBPCNY=SAEC, setting the tone for the yuan to climb against the euro EURCNY=CFXS, closing at 8.3722 on Tuesday versus a close of 8.4325 the previous day.

The yuan can rise up to 3 percent against currencies other than the dollar. The question is how far the yuan can go, said a senior dealer at a North American bank in Shanghai. We believe the central bank must have some limits, which may gradually become clear over time after the G20 summit.

Offshore dollar/yuan forwards bounced back after initial falls, triggered by the dollar/yuan mid-point setting, that had implied more yuan appreciation. Some players in the NDF market have turned cautious about shorting dollar/yuan, worried that this week's yuan move was engineered primarily to appease critics before the G20 summit late this week, and that later moves may be more subdued.

Three-month dollar-yuan non-deliverable forwards (NDFs) CNY3MNDFOR= were quoted at 6.7460, implying a yuan rise of 0.77 percent, after they fell as far as 6.7080 in early trade. One-year NDFs CNY1YNDFOR= rose back to 6.6390 after hitting an initial low of 6.5970, trimming implied appreciation to 2.39 percent from 3.05 percent the previous day. (Editing by Eric Burroughs and Edmund Klamann)